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Make friends with a bear: ETFs for down markets

They have to be loving this summer's stock market drubbing over at the ETF company BetaPro Management.

"Our record volume days are days that show a lot of red on the screen," said Howard Atkinson, the firm's president.

Take Monday as an example. As oil prices plunged and the S&P/TSX composite index did likewise, the 26 exchange-traded funds in the Horizons BetaPro lineup (two more were added Wednesday) posted total trading volume of more than 16 million shares, the second highest yet for the company and an astronomical number by the usual standards of the Canadian ETF market.

HBP started the year with $500-million in assets and today it runs more than $1.8-billion. The reason: This family of ETFs offers an efficient way to profit in a down market, and both retail and institutional investors are starting to embrace them. Do not for a second imagine that the funds are mass-market products along the lines of other ETFs, however. In fact, they're somewhat sophisticated investing tools that can confuse and disappoint unwary investors.

HBP's funds cover 14 different stock and bond indexes and commodities. For each, you can buy a bull fund to profit in rising markets and a bear fund to benefit from falling markets.

Both the bear and bull funds differ from traditional ETFs in that they're leveraged. This means they use financial instruments called derivatives to offer double exposure to the markets so that a 1-per-cent move in the underlying index is supposed to give you a 2-per-cent change in your fund.

Think of the bull fund as a turbocharged version of existing ETFs and mutual funds. If the market rises, so does this fund. Bear funds gain ground when the market falls, and they fall back when it rises. Think of them as a simpler alternative to traditional down-market strategies like short selling and options.

Several HBP funds have been around for more than a year now and they've performed in a way that has generated several e-mails from readers questioning why returns sometimes deviate from two times the underlying index.

Let's go back to Monday's market mayhem, when the S&P/TSX 60 index of large-size blue chips fell a bit more than 1.9 per cent. You'd expect the HBP S&P/TSX 60 Bear Plus to have made about double that and the S&P/TSX 60 Bull Plus ETF to have lost the same. In fact, the price of the bear ETF rose 2.6 per cent that day while the bull fund lost 2.6 per cent.

Longer term, there are even more discrepancies between what HBP ETFs return and what you'd expect from their mandate to deliver two times the index. For the year through Thursday, the 60 index was up 1.6 per cent while the S&P/TSX 60 Bear Plus ETF was down 8.6 per cent and the bull plus fund was up 1 per cent.

Herein lies an important lesson for investors interested in HBP's lineup of bear ETFs at a time of broad market weakness. These products do in fact let you profit in down markets, but results can vary for a couple of reasons.

First of all, these ETFs are designed so that their net asset value represents two times the inverse of a change in the underlying index (market is up down 1 per cent, the NAV rises 2 per cent). Ideally, the NAV would be the same as the share price. But in practice, the end-of-day price for HBP ETFs can sometimes be somewhat higher or lower. Mr. Atkinson said this is not unusual for ETFs of all types, and he noted that daily closing share prices typically snap back into line with NAVs at the beginning of the next trading day.

The longer-term gap between HBP ETFs - both the bull and bear versions - and their respective indexes highlights the fact that the leveraged, "two times the index" effect is meant to work on a single-day basis and not necessarily over a longer period of time. The longer you hold, the more chance there is that your returns will deviate from the two-times pattern. Also, the more volatile the underlying index or commodity, the more deviation there will likely be.

There are two approaches to using bear market ETFs - as a way of hedging a traditional portfolio against a market downturn and as a way of speculating on short-term market moves. Most investors who use these ETFs are speculators.

BetaPro's Mr. Atkinson reports that the average length of time that an investor holds the firm's ETFs is about two weeks, or 10 trading days. But he says this is skewed by the fact that two-thirds of unitholders are institutional money managers, a group that is likely to be more active traders than retail investors. HBP estimates that individuals hold its products for an average of one or two months.

A speculative play with HBP bear ETFs might revolve around a belief that the energy sector is headed for a fall. One option would be to capitalize on a decline in the price of crude oil using the Nymex Crude Oil Bear Plus ETF. Or, maybe you believe that energy stocks will maintain a pattern of underperforming crude oil prices. In this case, you could buy the S&P/TSX Capped Energy Bear Plus ETF and benefit from declines in the S&P/TSX capped energy index, which includes the likes of EnCana, Suncor and Canadian Natural Resources.

Keep a close watch on your portfolio if you're speculating with leveraged ETFs. Remember, a bear market ETF would convert a one-day market rise of 2.5 per cent into a loss of 5 per cent. A few moves like that in a short period and you're cooked.

Hedging a portfolio with bear market ETFs is all about having something that goes up in a down market, even as most of your other equity holdings fall in value. Here's an example of how it might work from Mr. Atkinson that involves a portfolio where 70 per cent is invested in mainly Canadian stocks, 20 per cent is in bonds and 10 per cent in cash. To set up a hedge against a drop in the Canadian market, an investor could simply take the cash in the portfolio and buy the S&P/TSX 60 Bear Plus ETF.

"All of a sudden they're reduced their equities from 70 per cent down to 50 per cent," Mr. Atkinson said. "They have 20 per cent that will go up when the market goes down."

We've already seen how the share price of leveraged ETFs can wander off the "two times the underlying index" track. If you're holding bear ETFs as a hedge, this can disrupt your asset mix and give you more or less protection than you actually want. To remedy this, HBP offers a rebalancing tool on its website that tells you how much to buy or sell in order to get back to your target weighting (hbpetfs.com: look under Resources). Mr. Atkinson suggests rebalancing monthly if you're holding leveraged ETFs in volatile sectors such as energy and quarterly or semi-annually for calmer sectors.

Exchange-traded funds have grown hugely in popularity in the past several years because they're such a versatile way to build a portfolio. HBP's ETFs fit into this theme, but they're a much more specialized tool than most. Handle them carefully.

***

Hunting bulls and bears

The Horizons BetaPro family of exchange-traded funds offer a bull and bear option for investing in 14 indexes and commodities. Each is designed to provide 200 per cent exposure to the market, which means the the impact of everyday market ups and downs is doubled. Here's a look at how a few popular HBP funds have performed lately.

FundTickerMEROne-dayOne-monthYr.-to-date
S&P/TSX 60 Bull PlusHXU1.15%2.30%- 12.50%1.0%
S&P/TSX 60 Bear PlusHXD1.15%- 2.30%12.90%- 8.6%
Underlying Index: S&P/TSX 601.02%- 6.50%1.6%
S&P/TSX Capped Financials Bull PlusHFU1.15%- 1.50%- 19.20%- 31.3%
S&P/TSX Capped Financials Bear PlusHFD1.15%1.30%21.90%31.3%
Underlying Index: S&P/TSX Financials - 0.82%- 10.30%- 16.4%
S&P/TSX Capped Energy Bull PlusHEU1.15%6.40%- 18.30%29.6%
S&P/TSX Capped Energy Bear PlusHED1.15%- 6.40%17.20%- 35.6%
Underlying Index: S&P/TSX Capped Energy3.20%- 8.90%16.8%
* all price changes as of July 10

Quick facts on HBP ETFs

Mission: Bull funds give you double the performance of a target index, while bear funds give you double inverse exposure.

Availability: As ETFs, these funds are listed on the Toronto Stock Exchange and trade like stocks.

Fees: The management expense ratio is higher than most Canadian ETFs at 1.15 per cent

Other costs: Brokerage commissions apply when buying or selling

Liquidity: Trading volumes for many of these funds are extremely high by ETF standards

RRSP eligibility: Yes

More information: hbpetfs.com

More choice: U.S. market leveraged bull and bear ETFs are offered by such companies as Rydex and ProShares.

THE GLOBE AND MAIL

SOURCE: GLOBEINVESTOR.COM

© 2007 The Globe and Mail. All rights reserved.

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